With a new government at India’s center and positive macroeconomic fundamentals working in its favor, the private equity industry is expected to invest more actively into India over the short to medium term. In the past year, inflation has steadily tapered, the fiscal deficit has been reduced, domestic demand has seen an uptick and the external value of the Indian rupee has stabilized. The first quarter of 2015 started on a steady note, attracting US$2.8 billion across 130 deals, representing the best performing quarter since 2011.1
Key issues and challenges affecting Indian private equity stem from tax and regulatory bottlenecks, a mismatch in valuation expectations and a tough, competitive environment for good-quality deals. India is also experiencing a significant exit overhang, and the pressure to exit is expected to rise. As compared to the same period last year, exit activity for Q1 2015 was three times higher, with almost 50% of total exits effected through strategic deals. Macroeconomic conditions, exit environment and investor sentiment remain the top three growth influencers affecting Indian private equity in 2015.
The Indian Finance Act, 20152 (the “Act”) became law on May 14, 2015 after receiving the President’s assent. While this first, complete fiscal bill of the Narendra Modi government evidences the pro-investment proclivity of the administration, it falls short of removing tax uncertainties that continue to temper foreign investor appetite and affect private equity fund structures and deal terms. Below is an overview of some of the key reforms introduced by the Act, as pertinent to GPs and LPs in Indian private equity funds.
Clarity on Application of the Minimum Alternate Tax (“MAT”)
Fund sponsors have been concerned with the recent assertion by the Indian revenue authorities that a Minimum Alternate Tax (“MAT”) should be levied on their activities. The concept of MAT in Indian tax law has historically been used to tax profitable Indian companies that avoided tax by using exclusions, deductions and incentives. MAT is levied on the book profits of a company, when the overall tax paid is less than 18.5% of the book profits. An overwhelming consensus of Indian tax advisors suggests that MAT should not apply to foreign companies that do not prepare their accounts in accordance with Indian corporate law (i.e., foreign companies not having a place of business in India).
Reassuringly, the Act grants a prospective exemption from MAT to all foreign companies, including Foreign Portfolio Investors (“FPIs”), for the following streams of income: (i) all capital gains from transfer of marketable securities and (ii) interest, royalty and fees for technical services accruing to a foreign company. The government has also clarified that private equity funds in treaty jurisdictions such as Mauritius and Singapore fall outside the ambit of MAT.
Indirect Transfer Provisions and Retroactive Tax Threat Linger
By virtue of Section 9 of the Indian Income-tax Act, 1961 (“ITA”), capital gains are taxed based on the source of the gains. The indirect transfer tax provisions, which were introduced in the Finance Act, 2012 by way of Explanation 5 to Section 9(1)(i) of the ITA, expand the existing source rules for capital gains by “clarifying” that an offshore capital asset would be considered to have a situs in India if it substantially derived its value (directly or indirectly) from assets situated in India.
The Act limits the indirect transfer tax provisions to transactions where the underlying assets in India constitute at least 50% of the global enterprise value. Further, sellers that do not control the overseas target and hold less than 5% in the company will not be subject to the tax. However, these indirect transfer provisions remain on the books. Thus, despite rhetoric from the administration that notices assessing taxes based upon these provisions should be avoided, their codification in the ITA spells continuing uncertainty for foreign investors.
The Indian tax authorities can bring tax claims for a period of seven years, well after the harvesting cycle of a fund concludes and gains are returned to investors. In the face of a continued threat of retroactive taxation stemming from the indirect transfer provisions, private equity buyers seeking to acquire strategic or majority stakes are increasingly insisting on deal terms that require the seller to be liable for any retrospective tax demands. Sell-side fund managers claim that such tax indemnities would prevent them from returning capital to their LPs. The use of standard LP clawback provisions for future tax liabilities could be a way to accommodate these competing interests.
Safe Harbor Norms for Indian Fund Managers
The Act seeks to mitigate the risk of a permanent establishment to fund managers or investment advisors in India, thereby exposing the fund to additional tax liability, by promulgating certain safe harbor norms. The proposed regime provides that the eligible offshore funds will not become taxable in India merely because a fund manager undertaking fund management activities on their behalf is located in India.
Qualifying criteria for a fund are as follows:
- that the fund is a tax resident of a treaty country;
- the fund must be subject to investor protection regulations in such country;
- Indian residents do not contribute more than 5% of the fund’s corpus;
- the fund must have at least 25 investors;
- no individual investor can hold more than 10% in the fund;
- aggregate participation interest of 10 or less members and their connected persons must be less than 50% of the fund;
- the fund cannot invest more than 20% of its corpus in any entity;
- the fund cannot invest in an associate entity;
- the monthly average corpus of the fund cannot be lower than INR 1 billion;
- the fund cannot carry on or control and manage any business in or from India;
- the fund does not undertake any other activity in India that can result in a business connection; and
the fund must remunerate the fund manager on an arm’s length basis.
Further, qualifying criteria for the fund manager requires that:
- the manager is not an employee or connected person of the fund;
- the manager is acting in the ordinary course of his business; and
the manager is not entitled to more than 20% of profits earned by the fund from transactions carried out by the fund through the manager.
In light of the aforesaid conditions, particularly the condition that the fund cannot carry on and manage any business in or from India, the practical ability of India-focused funds, and in particular, India-focused private equity buyout/growth funds, to rely upon the safe harbor is doubtful. Funds with less than 25 investors, with anchor investors holding more than a 10% interest in the fund, and funds that hire their fund managers as employees (instead of independent contractors) will not be able to benefit from the safe harbor exemption.
Corporate Residence Test Widens Tax Net
Prior to the Act, offshore companies were treated as “non-resident” in India unless wholly controlled and managed from India. Accordingly, the income of such offshore companies was not taxable in India, unless distributed to an Indian resident shareholder. The Act codifies certain changes to the corporate residence test that could potentially bring several offshore entities within the Indian tax net. The higher threshold for qualifying as a non-resident could be a cause of concern for private equity investors.
The Act introduces the subjective test of place of effective management (“POEM”), taking the relevant financial year as a whole into consideration. POEM has been defined to mean “a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance made.”
This new subjective framework introduces the possibility that a company could be construed to be an Indian company by virtue of the fact that majority control is exercised by Indian resident persons, or where some portion of shareholding of the offshore company is held by non-Indian investors and Indian promoters exercise significant ownership and control. Once deemed a resident of India, a foreign company could be subject to taxation in India on the company’s worldwide income.
The new POEM standard for tax residency is likely to proliferate tax litigation in India for fund managers utilizing offshore carry structures, as well as for Indian companies with subsidiaries abroad.
Further Deferral of General Anti Avoidance Rules (“GAAR”)
Shying away from giving foreign investors the certainty that India’s threatened General Anti Avoidance Rules (“GAAR”) will be shelved for good, the Act defers GAAR by another two years. Once implemented, GAAR will apply only prospectively to investments made on or after April 1, 2017. Investments made prior to April 1, 2017 will be grandfathered, providing relief to managers already invested in India.
GAAR represents a major area of concern and uncertainty for India-focused fund GPs and LPs. GAAR provisions would give Indian tax authorities greater powers to examine cross-border transactions for signs of tax evasion. Such powers would include the power to override all tax treaties and to disregard, look through, or re-characterize business arrangements that are deemed to be impermissible avoidance arrangements. The Indian government has not yet issued promised guidelines to explain the implementation of GAAR.
Tax Pass Through For Certain Alternative Investment Funds
The Act provides a special tax regime for taxation of Category-I and Category-II Alternative Investment Funds (“AIFs”) registered with the Securities and Exchange Board of India (“SEBI”) and provides that foreign investment will be allowed into AIFs. The special tax regime provides for a tax pass through to the specified AIFs in respect of all income other than business income. Business income of the AIFs is taxable at the level of the AIFs at the applicable rates and is exempt in the hands of the unit holders.
Category-I AIFs are AIFs that invest in start-up or early stage ventures, social ventures, small and medium enterprises, infrastructure or other areas that the government considers as socially or economically desirable. Category-II AIFs are funds, including private equity and debt funds, which do not:
- lever their investments;
- use complex trading strategies; or
receive specific incentives or concessions from the government.
All non-business income payable to investors will be subject to withholding tax at the rate of 10% (plus applicable surcharge and education cess). This 10% withholding tax may deter foreign investors from investing into AIFs. In the absence of precise criteria to distinguish business income from capital gains, there is also a risk that the withholding tax will be imposed on other exempt income such as dividends and long-term listed gains, and an increased litigation risk over characterization of income.
Concessions for REITS and Infrastructure Investment Trusts
A new framework for Real Estate Investment Trusts (“REITs”) and Infrastructure Investment Trusts (“InvITs”) was introduced last year, and while investor interest in these instruments remains high, they have yet to be utilized due to absence of clarity around the tax incidence associated with these vehicles.
The Act introduces certain changes to the taxation regime for REITs and InvITs, with effect from the tax year beginning April 1, 2015. The pass through status to REIT investors in relation to interest income earned by the REIT from a special purpose vehicle (“SPV”) is now extended to rental income earned in respect of property directly held by the REIT. Further, a concessional capital gains tax regime will be available to sponsors of REITs who acquire units through a swap of SPV shares, subject to levy of a securities transaction tax.
Additional reforms to the overall tax treatment of REITs and InvITs are required before these instruments can be viable.
Extension of SARFAESI TO NBFCs
The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”) provides certain measures for recovery of non-performing assets. Non-banking financial companies (“NBFCs”) that (i) are registered with the Reserve Bank of India (“RBI”) and (ii) have an asset size of INR 5 billion shall now be entitled to SARFAESI protection, enabling them to expeditiously enforce security interests without court intervention. Furthermore, assets of eligible NBFCs can now be sold to asset reconstruction or securitization companies. Additionally, eligible NBFCs are now able to acquire security receipts issued by an asset reconstruction company or a securitization company.
Additional Tax Reforms Signal Positive Changes
India’s corporate tax rate of 30% (excluding surcharge and education cess) is one of the highest in the Asia-Pacific region. The government has signaled a gradual reduction of the corporate tax rate to 25% over a period of four years from 2016.
The Act also extends, by two years, the eligibility period for a concessional rate of 5% (plus applicable surcharge and education cess) withholding tax on interest payments made to FPIs with respect to INR denominated bonds of an Indian company or government securities. The benefit will now be available on interest payable through June 30, 2017. This extension should facilitate substantial debt investment into India.
Additionally, the lower house of Parliament has passed a bill introducing a single Goods and Services Tax ("GST"), subsuming most indirect taxes. GST is expected to rationalize India’s indirect tax regime and reduce the cascading effect of multiple taxes (including, inter alia, customs duties and service taxes) and also reduce administrative costs of compliance in relation to multiple taxes. The government expects to roll out GST with effect from April 1, 2016. It is anticipated that the implementation of GST will have profound effects for inter-state commerce and development of India’s supply chain infrastructure, and will enhance cost efficiencies for business operations.
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Despite continuing tax uncertainties and other legacy issues including exit overhang and currency fluctuations, the Indian private equity market has enjoyed a bull run over the past year or so, and seems poised to continue its upward trajectory in the short to medium term. Additional developments in the AIF, business trust (REIT/InvITs), and GST regimes can also be expected.